In construction accounting, the percentage of completion method is the preferred tool to account for revenues and direct costs of construction. If you are an owner of a contracting business, this is the best method of accounting. Learn how percentage of completion method for accounting in construction is calculated and recorded in the financial books of record for construction. Find out the advantages of this method over the completed contract method of accounting in construction.
Prior to learning about this method, it is best for the reader to understand the completed contract method of accounting in construction. See http://businessecon.org/2013/02/completed-contract-method-of-accounting-in-the-construction-industry/ to learn about this method.
This method of accounting is similar to the completed contract method except that the revenues and direct costs are recognized at the end of each accounting cycle. For most small contractors (building less than 20 houses per year), this is usually a monthly cycle. At the end of each month, each project is evaluated for the percentage of completion to that date. The change in percentage from the prior cycle is calculated and that percentage of expected adjusted contract revenue is transferred from the draws account in the liabilities section of the balance sheet to the profit and loss. See How to Read the Balance Sheet – Simple Format for a better understanding of how to read and interpret the balance sheet. In addition to the revenues, the direct costs incurred during that time period associated with that percentage change is also transferred to the profit and loss statement. For this method to be fully effective it is imperative that the accounting staff utilized the accrual accounting concept. This means that all bills received are recorded in the books of record if not immediately paid. In effect, there will be an accounts payable account on the balance sheet.
As the home buyer pays for the costs of construction, these payments are recorded in their project account as draws. At the end of the accounting cycle the contractor should tour the project and calculate the most accurate percentage of completion on that day. The following is a three step method for the contractor to follow at the end of each accounting cycle (monthly or quarterly) to calculate the revenue earned and the direct costs of those revenues.
Step 1 – Determine the Projects Percentage of Completion to Date and the Change in Completion
The best tool to evaluate the percentage of completion for a project is to use the draw schedule for the project. Most draw schedules break out into 2-3 percentage groupings. As an example, the mechanical rough in for a home is about 2%. As the project manager, if you are evaluating this, if the mechanical rough in is complete, then add two percent to the total. However, if the HVAC guy just started or is on the project site, odds are that he has not sent in a bill to the company, therefore give the percentage a zero for the rough in step. The key is to be able to match costs associated with the step to revenues earned. There is no sense in recording the revenue earned if there are no correlating costs to transfer to the profit and loss statement.
As the contractor, think this step through. Most new home construction projects take from seven to nine months to complete. So it would be abnormal to calculate a 50% change in one month’s time period. The most likely mathematical outcome will range between 9 and 17% in any given month. Anything less or anything calculation more than this range should be double checked. Next, look at the respective breakout sections in detail. Evaluate the true percentage of that respective step and be conservative in your approach. The following is example of using this conservative approach:
The roofer has delivered the materials, the felt is laid, the valleys and flashing are all nailed up. Pipe collars are on, and about half of the roof is shingled including the ridge vent. So the roof is clearly ½ done, but a better estimate is 60% because the flashing and valleys are complete. In reviewing the draw schedule or percentage groupings, it is determined that the roof is worth 1.75% of the entire project. Therefore, the roof is equal to 1.05% (1.75 * .60) of the entire project. To be conservative and allow for some errors, you use 1% in determining this step of the project.
Now add up all the steps and you have the total percentage that the project has progressed since the beginning of the project. Pull out last accounting cycle’s worksheet and subtract that percentage from the current percentage and you get the change in project completion.
Remember, if the change in completion is less than 9% or more than 17%, provide evidence and supporting documentation with notes as to how you derived this amount. It could be something as simple as a lot of rain delaying the dig for the footer to a material shortage for the particular step in the progress of the project. Now that you have the change in the percentage of completion it is time to determine the revenue earned during the accounting cycle.
Step 2 – Calculate the Revenue Earned for the Project
Calculating the revenue earned on a project to date is a three part process. The first part is determining the adjusted contract value. This means that on the final day, certain costs will occur at closing. These include real estate commissions, seller’s fees, grantor’s tax, legal fees, and some allowances. The contract will identify some of these costs. The contractor takes the entire contract amount and adjusts the total sales price by these adjustments to get the adjusted sales price.
The second part begins with the adjusted sales price. This dollar value is multiplied by the percentage of completion calculated to determine the actual dollar value of the adjusted sales price earned or completed to date.
The third part requires the value already claimed as earned to date. If in the prior month the contractor claimed 23% of the adjusted sales price completed and this month it is 36%, then subtract the prior month’s dollar value from the current total value to identify the change during the current accounting cycle. This is the revenue earned for the project for the current accounting cycle. Let’s assume the balance sheet has accumulated draws to date of $232,000 and $163,000 has been transferred to the profit and loss. This leaves $69,000 of draws that have not been transferred to the profit and loss statement to date. If the 13% change during the current accounting period is worth $92,820 then all of the remaining balance in the draw account is transferred to the profit and loss statement. In addition, another $23,820 ($92,820 less 69,000) is recorded as revenue and as a receivable from the customer on the balance sheet. In effect, there will be no balance in the draw account on the balance sheet.
It is not abnormal to have the customer owing the contractor money. Actually this is the norm for construction. It would be abnormal to have draws in excess of actual work done. This is true for two reasons, first, rarely do customers prepay for work; deposits are normal, but not large prepayments. Secondly, the mortgage or bank does not typically advance funds on the draw schedule. See Construction Draw Schedule for more information about draw schedules.
Now that the revenue has been recognized and the dollar value transferred from the balance sheet, it is time to address the costs of construction.
Costs of Construction Transferred to the Profit and Loss Statement
This is where accrual accounting is critical to determine the correct amount of costs to transfer to the profit and loss statements. In the completed contract method, I illustrated how the costs are accumulated in a Work in Progress (WIP) account in the assets section of the balance sheet. As bills arrive and the purchases, labor, and other types of costs are entered into the accounting software, they are classed (See Class Accounting in Construction for an understanding of classification accounting) and phased (See Phase Accounting in Construction – Part I for an introduction to phase accounting). The costs are also identified to one of the five direct costs group and entered into the accounting software assigned to the correct project. These costs accumulate in the Work in Progress Account (WIP). Each accounting cycle the costs are transferred to the profit and loss statement on a project by project basis based on the percentage of completion. The dollar amount transferred is determined by the change in total construction progress during the accounting cycle.
In principle, if the project is a certain percentage complete, and the projected costs are ZZZ,ZZZ dollars, then the respective percentage change is transferred from the WIP account to the direct costs section of the profit and loss statement. This is important to understand, it is extremely rare for the costs transferred to the profit and loss statement to exceed the existing balance in the WIP account for that project. Think about this for a moment. If the costs transferred are greater than the existing balance, then the contractor overestimated the costs to build the project. This rarely happens.
There should be costs in the WIP account that have not been transferred due to cost overruns. If this dollar value remaining in the WIP account exceeds the estimated costs by more than 3% then the contractor needs to evaluate the source of the cost overrun. This is explained and illustrated in another article. For now, the costs in the WIP account cannot go below zero on the books. If the remaining costs in the WIP account are less than 3% of the estimated costs of construction, then it is considered reasonable and there is no need for alarm or requirement to review the underlying reason for this cost overrun. It is transferred at the end of the project in the final determination of costs.
At the end of the accounting cycle, the percentage of completion method transfers the draws and costs accumulated on the balance sheet to the profit and loss statement based on the percentage of work completed during the accounting cycle. In effect, there should be little to no balance in the draws account and the project costs account at the end of the accounting cycle.
At the end of the project, both draws and work in process are set to zero based on completion of the project. One of the fundamental steps during the final days of the project is to get all costs (bills) into the accountant to get recorded to the WIP account. The more information in his/her hands, the more accurate the final calculation becomes. Once complete, the contractor should determine the final dollar costs to complete the project so the accountant can enter this estimated amount into the WIP account too. Once all costs are accounted for and the allowance issues, change order issues, and any additional revenues are determined, the final dollar amounts for revenues and costs can be transferred to the profit and loss statement for the company.
The advantage to this method is that the contractor has a better or more accurate understanding of the businesses’ earnings and matching costs through the current date. If understood correctly and with phase accounting, the contractor can use the information to make changes to the company’s production and estimating for future projects to correctly determine the costs and revenues needed to complete a project and earn the appropriate profit. Knowledge is Power.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.
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Other articles of interest to the reader related to the construction industry include the following:
Class Accounting in Construction – any contractor providing more than two types of construction services such as new home and remodeling or additions should use class accounting to better understand their respective divisions of operations.
Phase Accounting in Construction – Part I – this form of cost accounting is very beneficial to a contractor as it identifies the areas of efficiency and those that need improvements. It breaks down all construction projects into 9 different phases of construction e.g. site development, foundation & walls. When used with class accounting, a contractor can make continuous financial improvements to his operations and finally realize great profits.